Economic and market themes: 2014-05-16 China

I had intended to write the usual multi-country post today but because I have so much on China, I am going to focus there exclusively today.

The Chinese property bubble is bursting

Chinese wage pressure is rising

Chinese search for oil has increased geopolitical tensions

China. There have been a number of good articles in the financial press about the slowdown in housing in China. We are seeing property prices and transaction volume decline, especially in third-tier cities. This is leading to high vacancy rates and serious liquidity problems for property developers and cities dependent on land sales to pay escalating municipal debt.

There are a few salient takeaways from what is being called a property bubble. First, while we have seen downturns in house prices in 2008 and 2011, those two were more driven by regulatory measures to keep the market from running away. This time, tightening is one of the causes of the downturn but this downturn is being driven more by market forces due to an oversupply.

In third and fourth-tier cities, with populations of 1-3million people, housing inventories are 30 months’ sales, up from 25 months at the start of 2012, according to UBS. Compare that to six or seven months’ sales in a good market in the US. The FT reports that in 13 large Chinese cities out of 53 monitored by property consultant Centaline, the housing market is showing signs of distress. 45.5 million people live in the metropolitan areas of these cities, seven of which are provincial capitals: Hangzhou, Wenzhou, Shenyang, Changzhou, Dalian, Changchun, Xi’an, Fuzhou, Baotou, Jilin, Chongqing, Harbin and Xianyang.

CLSA analyst Nicole Wong reports that she and her team looked at 810,000 residential property units in 600 properties over the past year around China. What they found was rising vacancy rates. Over the past 5 years, the vacancy rate has been about 15%, compared to about 10% in the US. But Wong expects this rate to rise to 20% in China by 2016 or 2017. In third- and fourth-ties cities like Tangshan and Wenzhou, the rate is already higher, 16% on average versus 10% in the big metropolises like Beijing or Shanghai and 13% in second-tier cities. Wong believes all of this comes from over-investment in residential property, which makes up 12% of GDP. If that number falls as is likely, GDP will fall with it.

Now, even in the largest cities, transaction volume is declining with housing sales in the big four cities – Beijing, Shanghai, Shenzhen and Guangzhou – down 20% in April from a month earlier. Through April, housing sales fell 7.8% in value terms year-on-year.

Second, this has stung developers, and a liquidity crisis has formed. The FT reports that even before the downturn in volume this year, at the end of last year, five large developers – Yuexiu Property, Agile Property, Country Garden, Guangzhou R&F and Fantasia – were suffering. Revenues and profit margins were down and debt was rising, according to Moody’s. Yuexiu and Agile had just enough cash flow in 2013 to repay debts due in 2014. With cash flow lower, this definitely means banks will have to evergreen loans and roll them over or we will see defaults.

Third, and interconnected to the developer problem, cities are hooked on land sales to meet debt obligations. According to the FT, Zhejiang province relies on land sale revenues for almost 70% of government debt payments – and this doesn’t include hidden and contingent debt due to off-balance sheet government sponsored entities. Overall, Barclays says nine of 23 provinces rely on land sales for more than 40 per cent of their debt payments coming due.

Chart below from Barclays:

Again, we will need to see some evergreening of debt obligations or local government defaults would occur. I fully expect a pretend and extend dynamic to take hold in all but the most egregious cases here.

Fourth, remember that local government revenue is being impacted by declining growth rates in industry due to rebalancing at the same time all of this occurs. So the devastating impact of reduced land sale revenue combines with lower growth as a double for municipal government and their off-balance sheet financing vehicles. I am not close enough to the situation to harbour a guess as to how difficult the situation is but it is clear that all of this will affect credit growth negatively as lenders digest the losses over a period of time. That necessarily means continued slowing.

In other China-related topics, the wage pressure in China is continuing to see manufacturing leaving China. The latest news is of Chinese companies offshoring manufacturing to Africa. Faced with rising labor costs, Chinese companies are setting up new factories on the continent and hiring more Africans. The companies efforts will test whether the masters of low-cost manufacturing can be as productive in Africa as they are in China. Faced with rising labor costs, Chinese companies are building new factories in Africa and hiring more Africans, also as a bid to curry favour due to Chinese need for natural resources. At present, productivity is much lower in Africa but the cost pressure and the political need is sufficient that we are seeing this transformation.

The perception about Chinese labor practices in Africa is negative. The Ethics Institute of South Africa reported in February that 46% of respondents to a survey in Africa had a negative impression about Chinese employment practices. Only 19% were positive. 55% agreed with the statement that Chinese companies in Africa use only Chinese employees. And, yes, due to the low productivity problem, Chinese have typically employed an overabundance of Chinese workers in Africa. China sent 214,534 workers to Africa last year, one-fourth of all expat Chinese workers globally. That’s up 18% from 2011. The Wall Street Journal reports of some companies recruiting Chinese workers in Angola and Zimbabwe for even menial tasks like laying bricks and driving trucks.

The last China-related topic I wanted to bring up here is the budding territorial disputes. China has been in dispute with a number of the region neighbours including Vietnam, the Philippines, Indonesia, Malaysia and Japan because of islands situated in the ocean that various countries are laying claim to. As you would expect, the reason is oil. Now that the easy to find oil is harder to come by, deep sea drilling makes sense economically and there are abundant oil deposits in the South China Sea.

Chinese oil giant Cnooc believes more than one-third of China’s total oil and gas reserves may lie beneath the South China Sea. And with China’s burgeoning middle class and industrial growth, it wants that oil. EIA estimates 11 billion barrels of oil and 190 trillion cubic feet in proved and probable reserves are in the South China Sea. Of course, a good bit of those reserves are in waters claimed by Vietnam and Malaysia.

The most recent international dispute began earlier this month when Vietnam tried to stop China from drilling for oil from a deepwater rig off the Paracel Islands. China controls this area but Vietnam claims it as well. China had more than 80 ships around the oil rig, including an antisubmarine ship, according to the Vietnamese. But China denied it had any military vessels there. A Chinese Foreign Ministry spokesperson said Vietnam was disrupting Chinese companies’ normal operations and that China had to take necessary steps to ensure the security of facilities and personnel.

In addition, the spokesperson criticized US Secretary of State John Kerry who called China’s recent actions “provocative.” According to the FT, a top Chinese general blamed the US “pivot” to Asia for the mounting tensions in the South China Sea, which by the way have sparked violent anti-China riots. Speaking in Washington, General Fang Fenghui, chief of the general staff of the Chinese military, said, “certain countries are attempting to gain their own interest because they believe China is now developing its economy and the US is adopting this Asia-Pacific rebalancing strategy.”

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.